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ABC Company purchased a hexane extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated...

ABC Company purchased a hexane extractor 10 years ago for $120,000. It is being depreciated on a straight-line basis over 15 years to an estimated salvage value of zero. It can be sold today for $10,000. ABC is considering purchasing a new more efficient extractor that would cost $270,000 installed. The machine has an economic life of 10 years and will be depreciated using straight line depreciation. If the new extractor is purchased, annual revenues will increase by $60,000 for first 5 years and $ 50,000 for the remaining life. The annual operating expenses will decrease by $10,000 for the life of the extractor. You are the financial consultant for ABC Inc. ABC wants to know if it makes financial sense to replace the old extractor with new efficient extractor. How much it will have to invest initially in order to replace the old extractor and how it should finance the initial outlay? ABC has other extractors available whose net investment could be different from the new efficient one under consideration. You asked for ABC’s balance sheet information. The relevant information is given below. After discussing with company officials, board members and other constituencies you realize that ABC’s capital structure is optimal. Balance Sheet Current Assets $40,000,000 Accounts Payable $20,000,000 Fixed Assets 400,000,000 Other current Liabilities 10,000,000 Total Assets 440,000,000 Long-term Debt 123,000,000 Preferred Stock 100,000,000 Common Stock 187,000,000 Total Liabilities & Stockholder’s Equity 440,000,000 You have obtained the following information through discussion with the firm’s investment bankers and financial officers: Debt can be obtained through the issuance of bonds (at par) with a maturity of 20 years that will carry a coupon rate of 15 percent paid semiannually. The firm currently pays $3 per share in dividends. Dividends have grown at 30% for next two years. Dividend growth will then stabilize to a growth rate of 5% forever. 1
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The analyst expect the firm’s common stock to sell at a price of $38 two years from today (P2= $38) . The risk-free rate is 5%. The beta of the stock is 1.3 and the required rate of return for he market is 15%. The firm’s preferred stock pays a dividend of $2 and has a market price of $12 The firm is in the 40% marginal tax bracket. Help ABC make the decision. ABC would like you show every step of financial calculation that you went through before you reached the decision. ABC executives remember some concepts from their BA 341 class that they took 20 years back. So they have asked you, the consultant to refresh their memory and help them make the right decision. They insist on a detailed analysis using time- line, so that they are able to visualize the problems in terms of cash flow. They also want you to give them an appropriate estimate for the required rate of return for the equity that they will be issuing. They know that there is more than one way to calculate the required rate of return and thus have asked you to use the constant growth model and the CPAM model to estimate the required rate of return for the equity. To reconcile the differences between the two models they understand that you will be using the average required rate of return for equity to calculate the weighted average cost of capital. To answer this question it is recommended that you follow the following steps. a.Calculate the net investment (NINV) required to replace the old extractor with the new extractor. (Hint: Do not forget to consider the tax savings from sale of the old extractor. For calculating tax savings, first calculate book-value of old extractor.) b.Compute the annual net cash flows (NCF) associated with the purchase of the new extractor. Hint: Do not forget to consider change in depreciation resulting from old and new extractor) c.Calculate the capital structure of ABC Inc. (Hint: Refer to Balance sheet) d.Calculate the after-tax cost of each component (debt, internal equity and external equity) source of capital. e.Compute the weighted (marginal) cost of capital for each increment of capital raised. You will have to first calculate the size of each increment. (Hint: First Page 2 of 3
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Statement of proposal evaluation: Computation of cost of capital
Note 6
1. cost of preferred stock Note1
Computation of cash flows =Expected dividend /net current price of preferred stock...

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